In recent years there has been criticism of the traditional system of costing for overheads ( Kaplan & Cooper ). Traditional cost systems were designed when:

• direct costs were the dominant factory costs;

• overhead costs were relatively small;

• Information processing costs were high;

• there was a lack of intense global competition;

• a limited range of products was produced.

Traditional product costing measures accurately volume-related resources eg. direct costs but they fail to measure the way products consume non-volume related activities eg. support services like material handling, set-up costs, inspection costs. Resources are used up when these activities are triggered by production. It is the products which cause these activities to arise and ABC attempts to trace the consumption of these activities by the various products. Products which demand a lot of activities and resources are allocated an appropriate share of the overheads. For example, a new product will probably be low volume initially, requiring a lot of machine set-ups, quality testing etc. so it should bear the overheads it is causing to be created.

Example: Two products A and B are produced ( 5000 units of A and 45000 units of B). Each product requires the same number of machine/direct labour hours.

Number of set-ups: A = 10 B = 5

The cost of set-ups is £1.2m.

Absorption costing:

Product A = £120,000 (10% of £1.2m.) / 5000units = £24 per unit

Product B = £1.08m (90% of £1.2m.) / 45,000 units = £24 per unit

ABC system:

Product A = £800,000 (10/15 x £1.2m) / 5,000 units = £160 per unit

Product B = £400,000 (5/15 x £1.2m) / 45,000 units = £8.89 per unit

Since product A, the low volume product is responsible for the greater share of the set-up costs it is only right that it attracts most of this overhead. It is the number of set-ups that is the cost driver. The traditional costing system tends to overcost high volume products and undercost low-volume but complex products.

Definition: Activity based costing (ABC) is concerned with ‘cost attribution to cost units on the basis of benefit received from direct activities eg. ordering, set-up, assuring quality’.

ABC states that activities cause costs and products/cost units consume the activities. It is used by management to determine the most profitable products and to appreciate the cost implications of the operational activities within the business. It gets management to understand what causes costs. The technique uses cost drivers to attribute costs to activities and cost objects. Thus, overheads can be related to the activities which cause them.

ABC divides activities into four categories:

1. Unit level activities which arise each time a product is manufactured eg. machine power, depreciation of machinery etc.

2. Transaction level activities which arise each time a transaction happens eg. quality control, inspection costs, set-up costs etc.

3. Plant level activities which relate to costs arising from the maintenance and operation of the business facilities.

In absorption costing overheads are assigned to cost centres and charged to cost units by usually a volume-based measure such as machine or labour hours whereas ABC uses a two-fold approach by locating costs in cost pools and identifying cost drivers to facilitate assigning costs to cost units.

In product costing it is relatively easy to charge direct costs to cost units but the problem arises in relation to indirect costs(overheads). Overhead costs(resource costs) such as rent, rates, maintenance costs, cleaning materials etc. which can be identified with a particular cost pool are located there. Other overheads which cannot be identified with a cost pool are apportioned to the cost pools by means of cost drivers which are the main determinants of the cost of activities. These overheads are pre-determined in that they are part of the budgeting process. These cost drivers might include the number of production runs, the number of customer orders received, the number of quality control tests, etc.

Activity cost pool	Activity cost driver
Advertising	The value of sales in each sales area
Quality control	The number of quality tests
Purchasing	The number of purchase orders
Set-up costs	The number of set-ups/production runs
Stores	The number of material requisitions
Despatch	The number of despatch notes

When the overheads are located in the cost pools an average cost per transaction is calculated by dividing the total cost of an activity by the number of transactions performed. This average cost is then used to to charge each product with the amount of service demanded from each activity cost pool. Consequently, products are charged with a fairer share of the overheads they have helped to create. The result is more accurate product costing, better decision-making in respect to the product output mix and product pricing.

Example:

The ABC company produces two products X and Y and the following information is given:

	Product X	Product Y		Total
Production and Sales (units)	25,000	5,000		30,000
	--------	-------		--------
Unit cost (£)
Direct labour	25	20
Direct materials	15	5
Operating data
Machine hours	1	2
Labour rate per hour (£)	1	1
Number of set-ups	4	20
Number of inspections	40	80
Overheads
Production processing			£700,000
Set-up			£120,000
Inspections			£180,000

Required;

Calculate the product costs using (a) Absorption costing (b) ABC.

(a) Assuming the overheads are absorbed on the basis of direct labour hours.

Budgeted overheads £1,000,000

OAR = --------------------------- = ------------- = £2.50 per hour

Labour hours 400,000

All production overheads are located in one cost pool. The unit costs of products X and Y are:

	£	£
	X	Y
Direct labour	15.00	5.00
Direct materials	25.00	20.00
Overhead (2.50 per d.l.h.)	37.50	12.50
	-------	--------
	77.50	37.50
	-------	-------

(b) In ABC three cost pools are identified viz. production processing, set-up and inspection costs. The cost drivers are also identified eg.

Cost Driver	Basis
Production processing	Number of machine hours
Machine set-ups	Number of machine set-ups
Inspections	Number of inspections

The overheads per cost pool and the rate per cost driver are computed.

Production processing costs:

Production overhead £700,000

----------------------------- = ------------ = £20 per mach.hr.

Machine hours 35,000

Set-up costs:

Cost per set-up Set-up cost £120,000

---------------- = ------------ = £5,000 per set-up.

No. of set-ups 24